Interest Rate Risk II Chapter 9

Financial Institutions Management, 4/e By Kenneth Daniels

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Price Sensitivity and Maturity

The longer the term to maturity, the greater the sensitivity to interest rate changes. Example: Suppose the zero coupon yield curve is flat at 12%. Bond A pays $1762.34 in five years. Bond B pays $3105.85 in ten years, and both are currently priced at $1000.

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Example continued...
Bond A: P = $1000 = $1762.34/(1.12)5 Bond B: P = $1000 = $3105.84/(1.12)10

Now suppose the interest rate increases by 1%.

Bond A: P = $1762.34/(1.13)5 = $956.53 Bond B: P = $3105.84/(1.13)10 = $914.94 The longer maturity bond has the greater drop in price.

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Coupon Effect

Bonds with identical maturities will respond differently to interest rate changes when the coupons differ. This is more readily understood by recognizing that coupon bonds consist of a bundle of zero-coupon bonds. With higher coupons, more of the bonds value is generated by cash flows which take place sooner in time.
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Price Sensitivity of 6% Coupon Bond

r n 40 20 10 2 $802 $864 $919 $981
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8%

6% $1,000 $1,000 $1,000 $1,000

4% $1,273 $1,163 $1,089 $1,019

Range $471 $299 $170 $37

Price Sensitivity of 8% Coupon Bond

r n 40 20 10 2 $828 $875 $923 $981
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10%

8% $1,000 $1,000 $1,000 $1,000

6% $1,231 $1,149 $1,085 $1,019

Range $403 $274 $162 $38

Remarks on Preceding Slides

The longer maturity bonds experience greater price changes in response to any change in the discount rate. The range of prices is greater when the coupon is lower.

The 6% bond shows greater changes in price in response to a 2% change than the 8% bond. The first bond is riskier.
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Duration

Duration
Combines the effects of differences in coupon rates and differences in maturity. Based on elasticity of bond price with respect to interest rate.

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Duration
Duration D = Snt=1[Ct t/(1+r)t]/ Snt=1 [Ct/(1+r)t] Where

D = duration t = number of periods in the future

Ct = cash flow to be delivered in t periods n= term-to-maturity & r = yield to maturity.
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Duration

Duration
Weighted sum of the number of periods in the future of each cash flow, (weighted by respective fraction of the PV of the bond as a whole). For a zero coupon bond, duration equals maturity since 100% of its present value is generated by the payment of the face value, at maturity.
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Advantages to Duration Measure:

1. Simplicity 2. Can be used to determine elasticity between price and YTM: (DP/P)/(Dr/r) = -D[r/(1+r)] We can rewrite this as: DP = -D[P/(1+r)] Dr

Note the direct relationship between DP and -D.

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Duration as Index of Interest Rate Risk:

The greater the duration, the greater the price sensitivity and the greater the risk. Higher duration indicates that it takes a longer time to recover the PV of the bond. This agrees with intuition once we realize that ONLY a zero-coupon bond has duration equal to maturity. ALL other bonds will have duration LESS than maturity.
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An example:

Consider three loan plans, all of which have maturities of 2 years. The loan amount is $1,000 and the current interest rate is 3%. Loan #1, is an installment loan with two equal payments of $522.61. Loan #2 is a discount loan, which has a single payment of $1,060.90. Loan #3 is structured as a 3% annual coupon bond.
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Duration as Index of Interest Rate Risk

Yield Loan Value 2% 3% Installment $1014.67 $1000 Discount $1019.70 $1000 Coupon $1019.41 $1000 DP $28.98 $38.84 $38.27

n 2 2 2

D 1.493 2.000 1.97

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Calculating Duration
Time 1 Cash flow PV of Cash Flow weight 0 0 0 weight*Time 0*1=0

1060.90

1000

1*2=2
Duration =2

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Calculating Duration
Time 1 Cash flow PV of Cash Flow weight 522.61 507.39 .507 weight*Time .507*1=.507

522.61

492.61
1000

.493
1

.4932*2=.99
.507+.99=

Duration =1.497
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Calculating Duration
Time 1 Cash flow PV of Cash Flow weight 30 29.13 .029 weight*Time .029*1=.029

1030

970.87
1000

.971
1

.971*2=1.94
.029+1.94=

Duration =1.97
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Limits to Duration Measure

Duration relationship may not hold if the bond has a call or prepayment provision.
Convexity. Negative Convexity.

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Special Case and an Adjustment

Maturity of a consol: M = . Duration of a consol: D= 1 + 1/R Adjusting for semi-annual payments dP/P = -D[dR/(1+ (1/2)R]

dP/P = -MD[dR]
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Duration and Price Sensitivity

dP/P = -MD[dR]
dR = basis point change in yield/100 basis point = 1/100 = .01 therefore 1% equals 1.00 = 100/100 = 1
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Duration and Price Sensitivity

An example- Typical Bond 7 1/4 coupon rate September 14 September 15 Yield(%) 9.55% 9.63% Yield in basis points 955 963 Price $886.25 $882.50

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Duration and Price Sensitivity

Example Continued Change in Yield = 8 basis points dR = 8/100 = .08 MD = 5.6409/1.0955 = 5.149 dP/P = -MD[dR] = -5.149*.08 = -0.41% *This is the estimated price change ex ante.* The expost price change is -0.42%
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Duration and Interest Rate Elasticity

E= interest rate elasticity= -MD*R An example- annual coupon bond R = 10.20%, coupon rate = 12%,par=$1,000 maturity is 10 years D = 6.5156 MD = 6.5156/(1.1020) = 5.91 E = -5.91*.1020 = -0.60
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Duration and Interest Rate Elasticity-Continued

Suppose the expected change in yields was 18 basis points, what price change would you expect based upon MD dP/P = -MD*dR MD = 6.5156/(1.1020) = 5.91 dR= 18/100= .18 dP/P = -5.91*.18= -1.064%
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Duration and Interest Rate Risk

Lets do an example for a semi-annual bond Assume 3 year, 8% semi-annual coupon bond with an initial yield of 10%. What is D, MD, dP/P and E ? D = 2.72 MD = 2.59 E = -.259 assuming a -2% change in yields dP/P = -2.59*-2= 5.18% Irwin/McGraw-Hill

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Immunizing Balance Sheet of an FI

Duration Gap:
From the balance sheet, E=A-L. Therefore, DE=DA-DL. In the same manner used to determine the change in bond prices, we can find the change in value of equity using duration.

DE = [-DAA + DLL] DR/(1+R) or

DE = -[DA - DLk]A(DR/(1+R))
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Duration and Immunizing

The formula shows 3 effects:

Leverage adjusted D-Gap The size of the FI The size of the interest rate shock

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An example:
Suppose DA = 5 years, DL = 3 years and rates are expected to rise from 10% to 11%. (Rates change by 1%). Also, A = 100, L = 90 and E = 10. Find change in E. DE = -[DA - DLk]A[DR/(1+R)] = -[5 - 3(90/100)]100[.01/1.1] = - $2.09. Methods of immunizing balance sheet.
Adjust DA , DL or k.
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*Limitations of Duration
Only works with parallel shifts in yield curve. Immunizing the entire balance sheet need not be costly. Duration can be employed in combination with hedge positions to immunize. Immunization is a dynamic process since duration depends on instantaneous R.

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*Convexity
The duration measure is a linear approximation of a non-linear function. If there are large changes in R, the approximation is much less accurate. Recall that duration involves only the first derivative of the price function. We can improve on the estimate using a Taylor expansion. In practice, the expansion rarely goes beyond second order (using the second derivative).
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*Modified duration
DP/P = -D[DR/(1+R)] + (1/2) CX (DR)2 or DP/P = -MD DR + (1/2) CX (DR)2 Where MD implies modified duration and CX is a measure of the curvature effect. CX = Scaling factor [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield] Commonly used scaling factor is 108.

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*Calculation of CX

Example: convexity of 8% coupon, 8% yield, six-year maturity Eurobond priced at $1,000. CX = 108[DP-/P + DP+/P] = 108[(999.53785-1,000)/1,000 + (1,000.46243-1,000)/1,000)] = 28.
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The Impact of Convexity

DP/P = -D[DR/(1+R)] + (1/2) CX (DR)2 or DP/P = -MD DR + (1/2) CX (DR)2 Textbook example Six year eurobond -8% coupon rate DP/P = -MD DR =(-4.99/1.08)*-2 = 9.25% increase as rates fall by 2% actual increase is 9.84% a large error

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The Impact of Convexity

DP/P = -D[DR/(1+R)] + (1/2) CX (DR)2 or DP/P = -MD DR + (1/2) CX (DR)2 Textbook example-continued Plug in the convexity factor DP/P = -MD DR+ (1/2) CX (DR)2 = 9.25% + (1/2)28 (.02)2 =9.81% reduces the error

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The Economic Meaning of Convexity

Convexity captures the earnings power of a fixed income portfolio. Fixed income portfolios can be ranked by convexity(CX) and duration (D). Consider a fund manager with a 15-year pay-out horizon.

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The Economic Meaning of Convexity

Strategy 1 Invest 100% of resources in a 15-year discount bond D = 15 CX =206 Strategy 2-Barbell Strategy Invest 50% in Fed Funds and 50% in 30-year Treasury, D =15 but CX = 398.5 Which would you chose? Irwin/McGraw-Hill

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